Today, it is very important to understand how banks and other financial institutions calculate the interest rate on a loan before going to apply for the same. Well to describe it simply, when you take a loan for a particular tenure, you need to repay not only the principal amount within that tenure but also the interest on the loan. How the bank/ financier calculate the interest is very important. ‘X% p.a.’ charged on Flat basis is certainly not same as ‘X% p.a.’ charged on Reducing / Diminishing Balance (also referred to as Effective Interest Rate).
What Is Flat Interest Rate?
Flat interest rate is an interest rate calculated on the full original loan amount for the whole term without taking into consideration that periodic payments reduce the amount loaned. In other words, Flat Rate of Interest basically means that interest is charged on the full amount of the loan throughout its loan tenure. Thus the flat rate does not take account of the fact that periodic repayments(EMI), which include both interest and principal, gradually reduce the outstanding loan amount. Consequently the Effective Interest Rate is considerably higher than the nominal Flat Rate initially quoted. For Example, For instance: If you take a loan of Rs 200,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay:
Rs 40,000 (principal repayment @ 200,000 / 5)
+ Rs 20,000 (interest @10% of 200,000)
= Rs 60,000 every year or Rs 5,000 per month.
Over the tenure of the loan, you would end up paying Rs 300,000 (5,000 * 12 * 5). Thus in this example, monthly EMI of Rs 5,000 translates to an Effective Interest Rate of 17.27% p.a.
What Is Reducing / Diminishing Interest Rate?
In Reducing / Diminishing Balance Rate method, interest is calculated every month on the outstanding loan balance. EMI payment every month contains interest payable for the outstanding loan amount for the month plus principal repayment. On every EMI payment, outstanding loan amount reduces by the amount of principal repayment. Thus interest for next month is calculated only on the outstanding loan amount as reduced by the principal repayment this month.
For example, if instead of 10% p.a. flat rate (in the above example), interest is charged at 10% p.a. reducing balance rate, EMI amount would reduce with every repayment. With Reducing Interest Rate, The first year you would pay Rs 20,000 as interest, the next year you would pay Rs 16,000 on a reduced principal of Rs 160,000 and so on, till the last year, you pay only Rs 4,000 as interest. Now you would have paid back Rs 2.6 lakh instead of Rs 3 lakh as in the earlier case.
Difference Between Flat Interest Rate And Reducing Balance Rate
- In a flat rate loan, the rate is calculated on the principal amount of a loan, while in a reducing balance loan, interest rate is charged only on the outstanding amount of a loan on a periodic basis.
- Flat interest rates are normally lower than the reducing balance rate.
- It is easier to calculate the Flat interest rate whereas calculating reducing balance rate is little complex.
- In real time scenario reducing rate option is better over flat rate when you borrow money.